Harned calculated the consequences to Pennco of a selloff as follows:

Harned estimated that there would be a sell-off to between 10 and 15. Thus Pennco faced an asset loss at market value of up to a quarter of a billion dollars. This would occur at a time when Pennco was planning a public financing and while all the common stock of Pennco was pledged on a $300 million revolving credit line.

254

Harned and other members of the group working on the prospectus were at the Dallas home of George Davis, GSC's outside counsel, for an evening work session, when Harned expressed his feeling that the offering should not be made. After some discussion, Harned then flew to California to tell Baker of his conclusions. Baker acquiesed.2 Harned then returned to New York where he told O'Herron about the disclosure problems and the effect this disclosure would have on the price of the stock. By this time, Harned had obtained the concurrence of other senior Glore Forgan officials in his recommendation. 255 The offering was dropped and no further information was put forth by Great Southwest or Penn Central on this sudden demise or the reasons behind it. Harned's forecast of a sell-off was accurate, although the period of the sell-off was extended because accurate information merely seeped into the marketplace. By year end the price was 16; by the end of March it was 14 and at the end of May it was six. It is clear that the managements of Great Southwest and Penn Central realized that the true nature of Great Southwest's earnings, activities, and prospects were shockingly less than what was being actively represented to the investing public. For management the registration statement was the moment of truth. The managements avoided that moment, and continued a calculated course of deception.

In addition to information concerning the inflated and short-lived earnings, the prospectus would have contained a considerable amount of additional adverse information. The draft prospectus disclosed the extent of the railroad's cash contribution, through Pennco. This cash was needed to meet the severe cash drain at Great Southwest. Loans from Pennco to GSC and Macco were:

Davis and members of GSC management tended to be vague on the reasons for the abandonment of the offering. They indicated that the principal reason was that the offering was "premature."

258 Charles Hodge, a partner of Glore Forgan and a director of GSC, was not available for consultation during this period.

The company received additional cash through purchase of securities by the parent:

The prospectus hinted that the flow of cash from the railroad might not continue indefinitely:

To the extent that it has been unable to obtain outside financing, the company in the past has obtained funds from Pennsylvania Co. and its affiliates. The company may not be able to obtain similar loans in the future and accordingly, will be required to obtain all its financing from lenders not affiliated with the company.

The prospectus also indicated that GSC faced $80 million of scheduled debt payment in 1970 and that 52 percent of GSC's stated assets were receivables, almost all of which were from bulk land sales. The prospectus also outlined the option which GSC had to acquire Macco and the benefits which accrued to Pennco when GSC acquired Macco in 1969 through negotiation with Pennco and not through the option.256 Pennco received $274 million worth of GSC securities in exchange for Macco. If GSC could have exercised its option, it could have obtained 99 percent of voting control of Macco for $61 million according to calculations in the draft perspectus. The terms of the option provided that it could be exercised after Macco repaid to Pennco the original purchase price ($39 million). The prospectus stated that the option had not been exercised because (1) GSC or Macco might not have been able to obtain the financing; (2) that GSC could not have compelled Macco to repay the Pennco debt; and (3) that Macco could not have required Pennco to accept repayment (the debt had been converted to preferred stock.)

In connection with the acquisition of Macco by GSC in 1969, as just described, Glore Forgan received 641,450 shares of GSC (valued at $11,500,000 on March 21, 1969 market price). This, too, appears to have been a favorable adjustment of earlier agreements, according to the draft prospectus. When Macco was acquired by Pennco, in 1965, Glore Forgan received 10,000 shares of Macco (10 percent of the outstanding common stock) for $10,000. At the same time, Glore Forgan gave GSC an option to purchase the 10,000 Macco shares for 100,000 GSC shares after Macco had repaid Pennco the $39 million which had been advanced to permit the original acquisition. In the 1969 agreement which joined GSC and Macco it was stated that GSC released its option to purchase Macco shares from Glore Forgan in exchange for Glore Forgan voting its Macco stock in favor of the merger. In negotiation, Glore Forgan received 641,450 shares of GSC in exchange for

256 The option was granted because GSC had found and evaluated Macco before its acquisition by Pennco.

its Macco warrants.257 According to the description in the draft prospectus, if GSC had been able to exercise the original option it would have paid Glore Forgan only 100,000 shares (valued at $1,500,000) rather that 641,450 shares (valued at $11,500,000). Approximately 600,000 of the shares received by Glore Forgan, were distributed to Glore Forgan officers.

The prospectus also reveals that after GSC's annual report for 1968 was issued, but prior to filing tax returns, GSC changed its income reporting so that earnings previously reported on the installment basis were reported as 1968 taxable income.258 Net earnings for 1968 were increased $7,036,508 above the previously reported amounts. This information appears as a footnote to the financial statements. It appears that this change in reporting was expressly undertaken to permit higher earnings reports to prospective investors.259

The draft prospectus also provides some information on individual development projects. A careful reading informs the reader that GSC had obligated itself for substantial development costs and that some land had serious hindrances to development.

The prospectus itself, as it appears in draft form, would not have disclosed the true condition of GSC, including Penn Central's dominant role and the plan of maximizing reportable earnings, but it gives hints of problems at Great Southwest.260 GSC and Pennco could not have afforded to tell even what was in the draft prospectus. GSC and Pennco failed to disclose the abundance of adverse information known at that time. The cancellation of the offering is a clear demonstration of the knowing and willing concealment of adverse information by Penn Central and Great Southwest.

FAILURE OF ALTERNATIVE EFFORTS TO SELL GREAT SOUTHWEST STOCK

The forced cancellation of the proposed public offering put pressure on Great Southwest and Pennco. Great Southwest had an urgent need for cash and Pennco needed reportable profits. The first alternative effort was a private placement by Great Southwest. GSC officials talked with several prospective buyers, including Bethlehem Steel Corp., but it was unable to find any buyers. Great Southwest's financial plight worsened.

Pennco still sought desperately to record gains for the sale of some of its Great Southwest stock. Such a sale was needed to boost the reported profits of Pennco, which had become the prime financing vehicle,261 and to boost the profits in the consolidated reports. It would also create the illusion for potential GSC investors that Great Southwest stock was desirable. The only avenue that could be found was a sale to the principal officers of GSC, Wynne, Baker and Ray. These officers were to purchase 1 million shares from Great Southwest for

Glore Forgan's interest in Macco had been converted from shares to warrants in 1967.

Macco was not covered by the tax allocation agreement in 1968 and did not deduct taxes from earnings Decause of the parent's loss carry-forward.

259 Memorandum from Bevan to Saunders, Sept. 11, 1969:

With respect to your memorandum of September 10 about the tax elections of Macco:

Messrs. Warner, Hill, Wilson, and myself met this afternoon and are unanimously of the opinion that we should go along with the Macco management's recommendation. This will add almost $0.50 a share to the reported earnings for last year, and merely on a basis of 10 times earnings will add $5 a share to the value of any stock sold, and if it goes to 20 times earnings it would add $10 a share. Our capital gains [from Pennco's participation in the sale of GSC stock] would be enhanced by this amount.

200 The prospectus was not filed with or reviewed by the SEC.

21 A proposed sale of GSC stock to GSC officers was mentioned in the Dec. 16, 1969, circular for the 30,000,000 Pennco debenture offering.

approximately $20 million. A refinement of the proposal called for the purchase of an additional million shares. Despite much activity, the scheme was not promising. Neither Baker, Ray nor Wynne had the resources to make this purchase.262 Even if resources could have been made available, it is doubtful that Baker and Ray ever would have committed themselves to such a dubious investment under terms making them personally liable for the purchase price.263

The scheme appears to have been developed by Bevan and Wynne.264 Wynne had helped found GSC and had lost his stock in his personal bankruptcy in 1964. Since that time he had been making purchases of the stock. Wynne apparently sought financing from several companies and individuals of his acquaintance but was unsuccessful.

At Penn Central, approval for the sale had been obtained from the Pennsylvania Co. board and the Transportation Co. board had been informed of the proposed sale. A considerable amount of planning for the transaction had been done by the Penn Central staff and an opinion letter as to a fair price for this non-arms-length transaction had been obtained from Salomon Bros. The existence of the proposed sale was reported in the $50 million Pennco debenture offering circular. The timing was important because Penn Central wanted the transaction completed for reporting in 1969's results. O'Herron described the program on the sale in a memorandum to Bevan on December 24, 1969:

3. The irrevocable note must be signed and dated prior to December 31 and the stock certificates delivered to Messrs. Wynne, Baker, and Ray in exchange for the note prior to the year end.

4. The note should be paid a few days before the date in January at which time Penn Central's earnings for the year are released. Therefore, for purposes of discussion we have set January 20 as the maturity date for the note. Assuming the note is paid on January 20, the profit and the transaction can be reflected in 1969 earnings.

5. PMM takes the position that in order to reflect the profit in 1969, the stock certificates must be delivered to Messrs. Wynne, Baker, and Ray without any strings attached. For example, a profit could not be booked if the profit was placed in escrow together with the irrevocable note.

The push for the completion of this scheme, which was never more than fantasy, reflects the desperation of Penn Central to generate reportable profits and to salvage scme demonstration that Great Southwest stock had some value. From a touted "billion dollar" asset Great Southwest stock had become something that first could not be sold publicly without making matters worse through disclosure; that later could not be sold privately; and that, finally, could not be sold to its own management.

Bevan made one other attempt to utilize Pennco's Great Southwest stock in financing. The $100 million Pennco debenture offer in 1970 was originally to have warrants attached for the stock of GSC and the stock of the holding company, Penn Central Co. Bevan attempted to

262 From testimony of Wynne:

A. I can't envision myself raising any $20,000,000, and I know that the other two people didn't have any money so that seems like a rather far-fetched idea to me.

263 From testimony of Ray:

Q. Would you have been willing to buy this stock, aside from any direct or indirect pressures that might have been put on you, if financing could have been obtained?

A. No, I thought it was goofy.

Q. Do you know whether Mr. Baker or Mr. Wynne shared your views on this?

A. I think Mr. Baker did.

264 Wynne testified that he had difficulty even recalling whether such a proposal had been made even after being shown a memorandum of a telephone conversation on the subject naming him as one of the participants in the conversation. Bevan testified that it was Wynne's idea.

use the GSC stock in this way based on the assumption that no registration with the Securities Exchange Commission would be required at the time of issuance, since the warrants would not be exercisable for 2 years. This plan shortly ran into difficulties. The initial difficulties were presented by counsel for the underwriters and by George Davis, the outside counsel for Great Southwest Corp. Davis was of the opinion that the issuance of these warrants would require immediate registration. Davis spoke with David Wilson, Penn Central's in-house securities counsel on February 20, 1970, and asked Wilson to intercede with Bevan to explain the problems of the issuance of these warrants to Bevan. At that time Davis raised the same problems that he had when the October 1969 issue was abandoned; namely, the disclosures about the condition and activities of Great Southwest Corp. In a memorandum of the February 20, 1970, telephone conversation, Wilson stated: 266

According to Davis, General Hodge and Jack Harned of Glore, Forgan, either severally or jointly, suggested to Davis that he call me with the proposal that Davis and I try to sit down with Mr. Bevan at a very early date and persuade him not to market any part of a GSC common stock offering at this time. I then proceeded to carry out the request of O'Herron and asked Davis what he planned to advise the board and management of GSC about the advisability of full disclosure of that company's affairs at this time. He replied very briefly that he would advise them to the same effect as he did last year when he persuaded them to abandon then current plans to register a GSC common stock offering. Among the reasons for his negative advice were (1) the current absence of any real cash earnings by GSC, (2) the tentative, conditional and rather silly nature of a lot of pending GSC transactions which would not have to be so described after 1 or 2 years from now, (3) some fairly questionable features about inside interests in GSC, its mergers, and so forth, which might not have to be explained in the future, (4) the inevitably depressing effect of these disclosures on GSC stock prices, and (5) considerations of a similar nature.

In subsequent meetings with the underwriters, principally First Boston Corp., the need for immediate registration was not agreed with by all parties. Davis testified that at one point he stated he would seek an injunction to prevent Pennsylvania Co. from issuing the warrants without registration. The underwriters were becoming gradually concerned about this and other disclosure problems and were considering the possibility of seeking a "no action" letter from Securities and Exchange Commission about the need to register these warrants. Finally it became understood among the parties that registration would be required. The plan for having warrants was then abandoned. 207

EXCHANGE OF GREAT SOUTHWEST STOCK FOR DEBT
OWED TO PENNSYLVANIA Co.

By December 1969, Great Southwest's debt to Pennco arising out of cash advances and obligations under the tax allocation was $25,210,977. This presented several problems to Penn Central and Great Southwest. GSC did not have the cash needed to pay the debt and, indeed, had a desperate need for additional cash. Not only was GSC unable to pay the debt, but its own financing efforts might be hurt by having this debt obligation on its balance sheet. For Pennco, the matter could be

26 Aside from the interpretation of the legal provision, Davis was aware of the serious disclosure problems and was concerned about having a fixed commitment to register even at a future date.

Davis testified that he was unable to recall discussions with Wilson on this matter. Wilson's memorandum appears to be an accurate presentation, however based on the circumstances and other testimony. For further information on the warrants and other disclosure problems with the Pennco offering see the section of this report on public offerings.